Chapter 7
The Stock Market, the Theory of Rational Expectations,
and Efficient Market Hypothesis
Because the stock market is of such great interest to students, this chapter discusses theories
of how stocks are priced and how information is incorporated into stock prices. Laying out the
simple models of the one-period valuation model, the generalized dividend valuation model,
and the Gordon growth model gives students the tools to understand how stock prices are
determined. Two applications show students how relevant these models are by applying them
to see how monetary policy influences stock prices.
The implications of rational expectations theory become much clearer when this theory is used to
understand behavior in the financial markets as in the efficient market hypothesis. Another area
of exciting new research has been on the validity of rational expectations and efficient markets,
and this is discussed in more detail in an appendix to the chapter, which can be found in MyLab
Economics. Research has been dredging up fascinating anomalies that cast doubt on these
theories. This chapter has therefore been written to give a more balanced view of these theories:
It reflects this latest research, including a discussion of the new field of behavioral finance,
which applies concepts from other social sciences such as anthropology, sociology, and
particularly psychology, to understand the often anomalous behavior of security prices.